Richard C. Longworth, senior fellow at The Chicago Council on Global Affairs, contributes his knowledge and ideas about issues that affect the Midwest.

Wednesday, October 31, 2012

Pop Goes the Bubble

Yogi Berra has reminded us that "it's tough to make predictions, especially about the future." With all respect for the Sage of St. Louis, I'm going to make a prediction that is sure to pan out. Here it is:

There is a big and growing bubble in farm land prices across the Midwest, and this bubble will pop, sooner or later. The result will be a rash of failed farms and rural misery.

We know this will happen because it's happened before, most recently thirty years ago. In the 1970s, a variety of factors -- mostly high grain prices -- sent farm land prices to record heights as farmers borrowed heavily to buy as much land as they could. Then, in the early 1980s, other factors -- mostly falling grain prices -- left many indebted farmers unable to pay their debts.

The result: thousands of Midwestern farms failed. Banks foreclosed. Many small rural banks, holding too many bad loans, also failed. Newspapers reported farmer suicides, even the murder of bankers by distraught farmers. Farm foreclosure sales became common social events. Most big farmers weathered the storm, but medium-sized farmers, whose debt soared by 250 percent in the 1970s, collapsed. Usually, they were bought by bigger farmers next door, accelerating the consolidation of Midwestern farming and the decline in rural population.

It's about to happen again. Reports from across the Midwest report that, once again, farm land prices have reached record heights, mostly because feed grain prices are also at record heights. The price of farm land in the five-state area covered by the Federal Reserve Bank of Chicago (Iowa, Illinois, Indiana, Michigan and part of Wisconsin) has gone up by double-digit percentages every year since 2005, except 2008, and rose another 15 percent since last year. In the Great Plains states, farmland prices have gone up even more, by 26 percent since last year (See New York Times article Across Corn Belt, Farmland Prices Keep Soaring).

As two Bloomberg reporters, Tim Jones and Elizabeth Campbell, wrote, "Farmland auctions in Iowa now resemble a dressed-down spectator sport with Sotheby's prices."

(Even as the world still reels from the bursting of the American sub-prime mortgage bubble, other property bubbles continue to inflate in other countries -- in China's biggest cities, for instance, and in Canada, especially in Toronto and Vancouver. What can I say? Some people never learn.)

In the worst American recession in 80 years, the farmland bubble doesn't make sense, especially in an area that just went thought its worst drought in a half century.

When things don't make sense, they stop. This bubble will end, too. We just don't know when.

What's going on? Mostly, it's fallout from soaring crop prices. While the rest of the nation suffers, Midwestern farmers have never done so well. Various factors -- especially strong exports to expanding economies like China and corn sales to meet government ethanol mandates -- have kept grain demand high and supplies tight.

Even the drought helped, by cutting output and keeping supplies even tighter. Corn peaked at $8.49 per bushel in August and soybeans at $17.89 in September. With prices like that, farmers are buying more land and more equipment, to produce as much of these golden crops as possible. What else will they do with their money? The stock market is anemic by comparison and money markets aren't going up at all, let alone by double digits.

As they say in the Midwest, buy land. They aren't making any more of that thing.

That's what they said in the '70s, too. Back then, new technology enabled farmers to grow more food, just like now. Interest rates were low just like now, so borrowing was cheap. Developing countries were growing, just like now, and their hungry populations could buy food. Mostly, the government pushed exports, just like now: the 1972 Russian grain deal opened the vast Soviet market to American crops (See Choices article The Role of Debt in Farmland Ownership).

Then it popped. Attempts to curb rampant inflation sent interest rates through the roof. The world entered a recession -- not as bad as now, but bad enough. And then Moscow invaded Afghanistan and President Carter retaliated by embargoing grain shipments to Russia.

The market went poof, the bubble went pop and the farmers went under.

Could it happen again? Bubbles have been popping for centuries. On the farm, it's almost generational. Farmers who bought land in the '70s were too young to remember the crash of the '30s. Farmers buying now haven't listened to their elders who remember the '80s.

We don't know why it will pop this time. The Russians won't invade Afghanistan again, but something will happen. It always does. Maybe China's economy will tank. Maybe world output will soar. Whatever, something will pop the bubble. You can bank on it.

Which reminds me: it takes two to make a bubble -- the borrower and the lender. Surely, you'd say, bankers would remember the '80s, or at least would have learned something from the sub-prime mortgage crash.

This misunderstands bankers. As the Chicago economist David Hale has said, "Bankers are programmed to lend." In bank-speak, the money in their vaults -- the deposits -- are "liabilities," because they have to pay interest on it. Granted, they're not paying much interest right now but, even so, deposits don't create profits. Profits come only when banks lend that money and charge interest rates on the loans. The same bank-speak calls loans "assets."

So bankers get paid to make loans. First, they make all the good loans they can. Then, having exhausted the good credit risks, they start making bad loans to bad credit risks.

That's what happens in bubbles. Every financial crisis you can think of, from the South Sea Bubble to the '80s farm crash to the sub-prime mortgage debacle is the result of bankers making bad loans. Government regulators should stop them but, as we've seen, bankers and their lobbyists work hard to keep regulators underpaid and underpowered.

As David Hale said, bankers can't help themselves. And it always ends in disaster.

That's what's happening now in the Midwest. Bankers who should know better are lending to farmers who should know better. Both are betting that corn prices and land prices will keep going up forever. But since nothing lasts forever, it's going to end. Badly.

2 Comments

Dick,
I was talking with an Iowa farmer about this just yesterday. He said there are record land prices in the NW of the state, and I asked about fear of a return to the 80's.

He said that today, buyers (here at least) are required to put down 50% compared to just 5% in the 80's. He said the screwy deals of the 80's where buyers only paid interest (no principle) for the first three years of the deal (and then often defaulted) are no longer allowed. He added that today, even with the rising prices, 75% of Iowa farm land is fully paid for.

Take that for what it is worth... one farmer talking. But I had the same fear you expressed. And I was feeling a little more confident until I read your blog today!

The Global Midwest Initiative of The Chicago Council on Global Affairs is a regional effort to promote interstate dialogue and to serve as a resource for those interested in the Midwest's ability to navigate today's global landscape.